David Cay Johnston emailed me that there were errors in Forbes contributor Tim Worstall’s recent criticisms of the linked article. Indeed there are, but the biggest one (or at least the funniest one) isn’t the one Johnston pointed me to.

Worstall writes that AbbVie’s pending inversion will not, by itself, reduce the taxes the company owes on its U.S. operations, though it could be a preparatory move to drain profits from the United States. I’ll come back to that point, but Worstall then gives the example of how AbbVie might sell its patents to a foreign subsidiary and pay royalties to that unit, thereby draining U.S.-generated profits to a tax haven subsidiary, for instance Bermuda (though Ireland is more germane in the real world for intellectual property). But then comes the zinger:

However, do note something else that has to happen with that tactic. That Bermudan company must pay full market value for those patents when they are transferred. Meaning that the US part of the company would make a large profit of course: thus accelerating their payment of tax to Uncle Sam. This tax dodging stuff is rather harder than it sometimes looks: if you’re going to place IP offshore you can do that, certainly, but you’ve got to do it before it becomes valuable, not afterwards. [link in original]

“Must pay full market value”? I’m falling off my chair! It’s like Worstall doesn’t think transfer pricing abuse exists. If patent, copyright, and other intellectual property transfers had to be made at full market value, they would never happen. As I explain in the linked post, academic research has shown that transfer pricing abuses, in this case underpricing the intellectual property transferred from the United States to Bermuda (again, really Ireland), are quite common when no arm’s-length market exists for a good. Since companies aren’t going to sell their crown jewels to strangers, how can a tax authority know what will be a fair price for a Microsoft patent going from the U.S., where it was derived, to its Irish subsidiary?

Let’s be a bit more precise. What would it take for Apple to buy all of Microsoft’s patents? In return for whatever lump sum Apple paid, it would need the equivalent back in terms of the present value of all Microsoft’s future royalty payments. But if Microsoft sold its patents to its Irish subsidiary at that price, Worstall would be right that there would be no tax benefit. And it’s not like it’s cost-free to organize such a transaction. Not only would Microsoft incur the costs of drawing up the contract and so forth, but nowadays companies are taking reputational hits as a result of their tax shenanigans: Ask Starbucks, Google, and Amazon. So if the transaction created no true savings, yet hurt a company’s reputation, we know that it wouldn’t make the transaction. The fact that multinationals are flocking to sell their intellectual property to Irish subsidiaries where the royalties are tax free tells us that the transfer price is not the “full market value” Worstall claims.

Moreover, contra Worstall, it isn’t a question of transferring the intellectual property before it’s valuable. If you’re a multinational drug company, you can make estimates of FDA approval, how much you think a drug will earn, and so forth. And you’ve got inside information! To take the simplest possible example, let’s say AbbVie has two drugs it thinks are each 50% likely to generate revenues with a present value of $500 million each. If you believe Worstall, it will sell one of the patents to its Bermudan subsidiary for only $250 million. But it will sell its other patent for another $250 million, so the supposed cost will still be $500 million and the subsidiary will expect to earn revenues equal to a present value of $500 million off whichever drug turns out to be successful. It’s inescapable that there is no point for a multinational company to sell the patent to its subsidiary at a fair price. There would be no tax benefit, and we wouldn’t be seeing Microsoft with $76.4 billion offshore or Apple with $54.4 billion offshore in 2013. Or a total of $1.95 trillion for 307 companies. Heck, even AbbVie has $21 billion permanently reinvested offshore, according to its 2013 Annual Report (downloadable here), p. 93. “Full market value,” indeed.

Finally, a note on Johnston’s and Worstall’s main dispute. Worstall argued that an inversion does not reduce the tax that a U.S. subsidiary would owe to the United States, noting that you can drain profits (except, as we saw, he doesn’t really believe you can drain profits) from the American subsidiary as long as you have a tax haven subsidiary, i.e., you don’t need inversion for that.

From a very narrow point of view, this is correct. But what Worstall overlooks is that, for the U.S., worldwide taxation substitutes for a general anti-avoidance rule making avoidance itself illegal, which is the approach most other industrialized countries take. Inversions make it impossible to police avoidance, so they indeed threaten tax collections from U.S. subsidiaries. But one might argue that deferral has almost completely neutered the benefit from worldwide taxation already. The bottom line is that the United States needs an end to deferrals at least until it adopts strong anti-avoidance rules, at which point it would only then be possible to discuss ending worldwide taxation.

But all of that will be for naught if we allow ourselves to be seduced by silly claims about how transfer prices have to be the same as “full market value.”

John Bluedorn and Shengzu Wang wrote a post on the IMF blog called, Euro Area: An Unbalanced Rebalancing? They talk about the unbalanced Current Account trade balances within Europe where creditor nations continue with large surpluses, even though debtor nations are moving toward surpluses themselves. They give reasons of competitiveness, increased saving and low investment. Their final conclusion is wrong because they do not incorporate the effects of effective demand.

Competitiveness

“Many debtor economies have seen their unit labor costs decline, improving competitiveness and boosting their current accounts… the bulk of competitiveness improvements in debtor economies has been accompanied by declining domestic demand and rising unemployment. “

Unit labor costs are just labor share divided by the price index. So when unit labor costs fall in a low inflation environment, labor share is falling too. Also, effective demand is falling. So it is no surprise that domestic demand is falling and unemployment is rising. (Unemployment rises when labor share falls, as an economy moves down the labor supply curve.

We see that effective demand is falling in Europe.

Increased Saving

“At the same time, many creditor economies have had large and persistent surpluses, driven by both higher saving and lower investment”

As labor share falls, domestic consumption decreases. The difference between domestic consumption and production gives national saving. So lower labor share is driving the Current Account surpluses in Europe.

Low Investment

“Restrained domestic demand (high saving and low investment) is part of the story behind the persistent surpluses in the creditor economies.”

The low investment is a result of low effective demand among labor/consumers.

The Wrong Conclusion

“Large and persistent surpluses in creditor economies contribute to a stronger euro, making it tougher for euro area debtor economies to adjust.

“To make the rebalancing more robust, policies are needed to boost investment in creditor economies and structural reforms to raise productivity in all euro area economies (through further liberalization of product and service markets and reforms to make labor markets more flexible). These would raise potential growth across the board and help output gaps close faster.”

First, productivity is constrained by effective demand. (link) So boosting productivity through increased investment is like expecting to pass through US customs without a Visa. You have to have the Visa first which represents raising effective demand.

Second, making labor markets more flexible will only create more capacity to lower unit labor costs, which will exacerbate the weak effective demand underlying the great Current Account surpluses in Germany and the high unemployment in the periphery.

Third, potential growth would not rise since productivity cannot be increased against the effective demand limit.

Fourth, the goal should not be closing the output gaps and raising potential output. The goal should be lowering unemployment, which is caused by weak domestic demand.

Fifth, the output gap will close faster only because effective demand is falling which pushes potential output down. Ultimately a country ends up with higher unemployment. We see examples of high unemployment in many countries.

The Right Conclusion

The problem is low labor share. So the solution is higher labor share. However, if there are larger forces pushing unit labor costs down globally, then there really isn’t any solution. But actively lowering unit labor costs makes the situation even worse.

I read an article by Gavyn Davies, Another False Alarm on US Inflation?. He states that projections of rising inflation are not warranted due to lack of wage-growth pressures. I agree with him, but I want to go one step further and say that the uptick in inflation is understandable.

I have written before about why inflation is low with low nominal interest rates. The reason is the Fisher Effect that says over time, inflation will adjust to a stable nominal rate and a natural real interest rate that is independent of monetary policy.

Inflation = Nominal rate – natural real rate

So if people expect a 3% nominal rate at a far-off full employment and the natural real rate at full employment is 2%, we would see inflation move asymptotically to 1% over time. We also need to see a central bank base rate locked into a specific range for a long time. If the CB base rate starts moving, there are short term reactions to inflation that disrupt the Fisher Effect.

Now if people begin to expect a higher nominal rate sooner, or better yet, if nominal rates are seen to be breaking above their specific range that they are perceived to be locked into, inflation will tend to rise. Firms will hedge the higher expected interest rates by raising prices.

This reaction of inflation to rise is typically seen towards the end of the business cycle when real GDP nears its natural level. People normally do not know when the business cycle will reach its natural end, so when the central bank base rates begin to signal that they are breaking out of a low pattern, people will know to expect higher nominal rates. Firms then raise prices in order to hedge the expected interest rate costs.

The signal to start raising rates is not an alarm. Yet one could see it as an alarm that real GDP is reaching its natural level.

“It hurts small business and kills jobs,” warned the Sacramento Taxpayers Association, the National Federation of Independent Business/California, and Joel Fox, president of the Small Business Action Committee.

So what happened after voters approved the tax increases, which took effect at the start of 2013?

Last year California added 410,418 jobs, an increase of 2.8 percent over 2012, significantly better than the 1.8 percent national increase in jobs.

He first comments on an article from Jeremy Grantham who says that a coming bubble is likely.

“. . . There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word ‘uniquely’ in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before.

“. . . I would be licking my lips at an economy that seems to have enough slack to keep going for a few years.”

(Now Bruce Carman writes…)
I suspect that Grantham does not understand the implications of effective demand. He assumes much more slack in the economy than there likely is.

I infer that he also assumes that the economy won’t experience the risk of recession until after the Fed raises rates and the yield curve inverts. But the yield curve does not invert before recessions and bear markets during debt-deflationary regimes, as in the 1830s-40s, 1880s-90s, 1930s-40s, Japan since 1998, and the US and most of the rest of the world in 2008 to date. Japan has experienced 4 bear markets and 3 recessions since the country’s yield curve last inverted in 1992. The US experienced a similar pattern from 1931 to the early to mid-1950s.

Moreover, the price of oil has accelerated YTD, yoy, and q-q annualized, resulting in CPI accelerating from 1.5% at the end of 2013 to 2.5% YTD and 3.8% q-q annualized for Q2, accelerating to a rate faster than yoy and annualized nominal GDP and reducing q-q annualized real income and wages for Q2 to ~0%. Therefore, we are experiencing a mini-oil shock (by duration so far) to an economy at a much slower secular trend rate of growth, risking no real growth or recessionary conditions most economists do not perceive (not publicly, in any case).

With the secular trend rate of real final sales per capita since 2000 and 2007 having decelerated from 2% to 0.8%, the US economy is much more vulnerable than otherwise to weather, energy, fiscal, and geopolitical shocks that cause periodic or consecutive q-q annualized contractions as occurred in Q1.
Thus, it appears that at the slow trend rate of real final sales/GDP, the US economy cannot withstand an acceleration of price inflation beyond 1.5-2% without stall speed or contraction. This is occurring in the context of the Fed implicitly targeting a 2% inflation rate, whereas some economists propose the wildly misguided policy of the Fed targeting 4-6% inflation to reduce the real interest rate burden from debt service. This would further obliterate real purchasing power of earned income for the bottom 90%.

As of the latest data releases for Q2, I have real final sales/GDP in the 2.1-2.5% range q-q annualized for Q2, which is 1.5% yoy, 0.8% yoy per capita, no growth or a slight contraction YTD, and no growth for 3 quarters running for real final sales per capita. This cyclical pattern of deceleration is historically recessionary.

The great Yitzhak Rabin has been long forgotten, assassinated by the Israeli ultranationalist, Yigal Amir–a forerunner of the cruel Zionist Netanyahu and the she-devil, Ayled Shaked. But the Zionist hard right would not have risen to power if it had not help from the West. Among those who blindly walk behind the Israeli tanks, the bombers, the gunships that now plow a bloody path through Gaza are The New York Times whose coverage consistently echoes Zionist talking points; the mad Christian right who proudly tour illegal settlements, praying nightly for the Second Coming; Republican and Democratic senators that simply cannot give Israel enough weaponry and take as gospel anything the crazy Zionists say.

What senator or Congressman has raised his or her voice against the settlements? What senator or Congressman objected to the latest Netanyahu claim that the Palestinians are cleverly using the telegenically dead to bulk the body count? What senator, Congressman, President, or Prime Minister or Secretary of State has called such a remark as obscene? Has The New York Times?

Simon Wren-Lewis writes about the difference between how the neofiscalists and market monetarists view the solution to the world’s economic woes. Basically, neofiscalists are ready to use whatever is necessary. Market monetarists limit themselves to creative monetary policy. He uses a car analogy.

“To understand why I do get annoyed with MM, let me use another car analogy. We are going downhill, and the brakes do not seem to be working properly. I’m sitting in the backseat with a representative of MM. I suggest to the driver that they should keep trying the brake pedal, but they should also put the handbrake on. The person sitting next to me says “That is a terrible idea. The brake pedal should work. Maybe try pressing it in a different way. But do not put on the handbrake. The smell of burning rubber will be terrible. The brake pedal should work, that is what it is designed for, and to do anything else just lets the car manufacturer off the hook”

The car, as it is built, is actually working like it is supplied to work. All the brakes work.The problem with the car is much deeper.

Fiscal and monetary policies are both ineffective against the true problem… which is a declining demand for labor, weak real wages and low labor share.
The problem is that we are all stuck in a traffic jam on the highway. Everyone is going slow. And everyone is trying to get to the same destination. There is a bottleneck slowing down traffic. Our economies have more engine power, but the we are forced to go slow.
Neither the brakes, nor the handbrake solve the problem. The solution is not to stop the car. You are in stop-and-go traffic. Even all the cars around you (other countries) are having the same problem. Even if you managed to stop the car, someone would crash into you from behind.

Neither fiscal spending nor monetary policy can move the car faster when stuck in a traffic jam. Neither will increase the deeper problem of weak labor.

The solution is to get off the highway and take an alternative route… an alternative economic system that cultivates more local ownership of businesses and capital by labor. The people of each country must benefit from the profits of their natural resources. The rich are not sharing the wealth from the natural resources that should belong to the people, not a select few.

Corporate “inversions” are back in the news again, as multinational corporations try every “creative” way they can to get out of paying their fair share of taxes for being located in the United States. With inversions, the idea is to pretend to be a foreign company even though it is physically located and the majority of its shareholders are in the U.S.

“What’s that?” you say. At its base, what happens with an inversion is that a U.S. corporation claims that its head office is really in Ireland, the Cayman Islands, Jersey, etc. Originally, all you had to do was say that your headquarters was abroad. Literally.

Now, the rules require you to have at least 20% foreign ownership to make this claim, but companies as diverse as Pfizer, AbbVie, and Walgreen’s are set to run rings around this low hurdle. The basic idea is that you take over a smaller foreign company and pay for it partly with your own company’s stock to give the shareholders of the foreign takeover target at least a 20% ownership stake in your company.

Thus, with pharmaceutical company AbbVie’s takeover of the Irish company Shire (legally incorporated in the even worse tax haven Jersey), Shire’s shareholders will own about 25% of the new company, thereby qualifying to take advantage of the inversion rules. It expects that its effective tax rate will decline from 22.6% in 2013 to 13% in 2016. Yet nothing will actually change in the new company: it will still be headquartered in Chicago, and the overwhelming majority of shareholders will be American.

As David Cay Johnston points out, even some staunch business advocates like Fortune magazine are calling this tax dodge “positively un-American.” Further, as he notes, Walgreen’s wants to still benefit from filling Medicare and Medicaid prescriptions even if it ceases to pay much in U.S. corporate income tax. In other words, it will get all the benefits of being in the U.S., including lucrative government contracts, without paying for the costs of government.

As I toldThe Fiscal Times, if companies like these get their tax burden reduced, there are only three possible reactions that can occur: someone else (i.e., you and me) will pay more taxes; the government must run a higher deficit; or government programs must be cut. Of course, there is a limitless number of combinations of these three changes that can result, but one or more of them has to happen.

What can we do about this? One obvious answer to to raise the bar for foreign ownership to at least 50%+ to call a company foreign. Even more comprehensive, as reported by Citizens for Tax Justice, would be to continue to consider a company “American” for tax purposes as long as it had “substantial operations” in the United States and was managed from the United States. Furthermore, the Obama Administration has proposed limiting the amount of deductions American companies can take for interest paid on loans “from” their foreign subsidiaries, thereby preventing what is often called “profit stripping.” Another idea, from Senator Bernie Sanders, would be to bar such companies from government contracts.

The whole concept of “inversions” no doubt sounds very arcane to the average person. But one of the bills to rein them in is estimated to raise $20 billion in tax revenue over the next 10 years. The stakes are substantial, so we need to take a minute to wrap our head around it if we want to head off yet another way in which the tax burden is shifted to the middle class.

News reports have been filled with conflicting theories explaining why tens of thousands of unaccompanied children from Honduras, El Salvador and Guatemala, have been streaming into the U.S. Some observers say that their parents are sending them here, so that they can take advantage of the social services and free education available in the U.S. Others argue that they are not coming here willingly, but that they have been forced to flee gang violence in their home countries that ranges from murder to rape. Still others charge that President Obama’s lax immigration policy has drawn these migrants to the U.S.